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Wednesday, April 13, 2005

Fed Policy in a Hard Landing

Let’s suppose Brad DeLong gets his wish:

…we need a really strong Treasury Department and a really strong Federal Reserve…

With our hypothetical really strong Treasury Department and really strong Federal Reserve, let’s suppose the hard landing scenario begins to unfold driven by the fear of a rapid dollar devaluation or because foreign central banks have decided that their inventories of U.S. assets are sufficient and do not wish to absorb any further debt.

Two things would make this a really strong Federal Reserve and Treasury team. The first is a necessary condition and Brad covered this nicely in the same post:

…Should that day come, keeping a financial crisis from becoming a major disaster may well require swift and rapid action by a Federal Reserve and a Treasury Department that have powerful and unconditional White House and Congressional support…

Thus, having the trust of the administration and congress, and the freedom to implement the optimal policy is necessary.

But that is not enough. The freedom to implement poor policy is not helpful. Thus, the second condition is that the team identify the optimal policy response.

What is the optimal policy? Here is the response as I see it, and I welcome other views. The main goal is to start a conversation on this topic, the optimal response of the Fed in various hard landing scenarios (so, if anyone else would like to post detailing how you would respond if you controlled both Treasury and The Fed...).

To get things started, let’s suppose that there is a sudden fear of a rapid dollar devaluation, or foreign central banks stop absorbing debt because their inventories of U.S. assets are sufficient. The reason this could happen is one we’ve seen often before in other countries, a federal budget deficit that is out of control.

If foreigners begin dumping debt or refusing to purchase new debt, then it is widely believed that interest rates will rise as the Treasury must offer higher rates of return (or a lower price) to sell new debt. For example, Kash at Angry Bear summarizes the case nicely here.  Thus, the first effect is:

1.  A rapid rise in interest rates.

Next, what about exchange rates, what would be expected to happen to the them?  As Kash at Angry bear notes in a separate post:

..When that happens, the US CA deficit must necessarily fall by a (roughly) similar amount over a short period of time. The only way that that can happen, particularly given continued US government deficits, is for a sharp fall in the dollar, a sharp rise in interest rates, a sharp fall in asset values, a sharp fall in consumption, and a large rise in US saving…

Thus, the second effect is:

2.  A sharp fall in the dollar.

Finally, what is expected to happen to domestic inflation? Quoting Kash at Angry Bear again, and as noted in macroblog:

..Thanks to suddenly expensive imports, there’s a spike in US inflation…

So, the third consequence is:

3.  A spike in U.S. inflation.

Because of the rise in interest rates, fall in the stock market, and so on described in the posts linked above, the final effect is

4.  A recession that occurs quickly.

This would put downward pressure on inflation so the overall effect on inflation isn’t clear, but I will assume for now that inflation increases followed by a reduction in inflation in subsequent periods due to pressures from falling output. Increases in oil prices could also cause inflationary and contractionary pressure.

Here is the policy response by the Fed as I see it assuming a continued move towards explicit inflation targeting and transparency.

The policy is to move immediately to stabilize the inflation rate around the target value. That does not mean however that the Fed should necessarily respond to contemporaneous inflation. Looking at the rest of Kash’s quote tells the whole story:

…Inflation in the US will jump upward very quickly, though perhaps only temporarily…

If the inflation effect is only temporary due to output falling, then it would be incorrect to increase the federal funds rate in response to contemporaneous inflation. It is expected future inflation and output that the Fed needs to consider in getting the inflation rate back to its desired path.

With an inflation target, the rule that actually implements the target is similar to a traditional Taylor rule. Thus, if inflation is expected to fall of its own accord, then the expected future output gap would call for the Fed to lower the federal funds rate even though inflation is currently rising. It is the expected fall in output in the future that dominates the policy response (so long as the assumption that inflation pressure is moderated after the initial burst is justified). The degree of the response depends upon the degree to which output is expected to fall. The harder and more sustained the landing, the more aggressive the policy response.

The lesson is an important one. Under inflation targeting, it is not the current inflation rate or output gap that dominates the policy response. The correct policy response is to move the inflation rate back to its desired path as soon as possible and in doing so it is the future path of important macro variables that dominate the Fed’s policy considerations. Quoting Woodford (pg. 292):

…it would be undesirable not to allow temporary fluctuations in inflation … the central bank should nonetheless provide clear assurances that inflation will eventually be returned to its long-run target level…

That is enough for now, particularly since I plan to continue this line of inquiry in future posts, and because I want to pause and think about all this more and hopefully give a more detailed description of the policy options.

[Update:  This topic is discussed further here along with a link to a Krugman column stating that there are no good monetary policy choices in a hard landing.]

Note: Federal Reserve Board governor Ben Bernanke, is scheduled to deliver a speech in St. Louis concerning the U.S. current account deficit on April 14, 2005.

Bernanke discusses policy in a speech in March as well. Interestingly, he does not mention monetary policy and does not believe fiscal policy changes themselves will solve the current account issue:

Remarks by Governor Ben S. Bernanke
At the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia
March 10, 2005

The Global Saving Glut and the U.S. Current Account Deficit

...What policy options exist to deal with the U.S. current account deficit? I have downplayed the role of the U.S. federal budget deficit today, and I disagree with the view, sometimes heard, that balancing the federal budget by itself would largely defuse the current account issue...

...However, as I have argued today, some of the key reasons for the large U.S. current account deficit are external to the United States, implying that purely inward-looking policies are unlikely to resolve this issue. Thus a more direct approach is to help and encourage developing countries to re-enter international capital markets in their more natural role as borrowers, rather than as lenders ... The factors underlying the U.S. current account deficit are likely to unwind only gradually, however. Thus, we probably have little choice except to be patient as we work to create the conditions in which a greater share of global saving can be redirected away from the United States and toward the rest of the world--particularly the developing nations.

[Update - Given the recent discussions of transparency here and here among other places, this article in MarketWatch is interesting: Potholes on Fed's road to openness. William Polley has been discussing this topic as well here and here, as has macroblog here.]

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